No More Payday Predators

That loan is more expensive than you might think.

Photographer: Mark Ralston/AFP/Getty Images

Feb 19, 2015 8:00 AM EST

If you were thinking straight, would you pay more than 300 percent in annualized interest -- or risk losing your home -- to borrow a few hundred dollars? If the answer is no, you might see the wisdom of regulating the short-term, small-sum credit commonly known as payday lending.

Typically aimed at low-income customers with spotty credit and cash-flow problems, the business has long been controversial. In its classic form, someone who wants to tap an upcoming paycheck borrows $100 to $500 and agrees to return the whole amount in a couple of weeks, along with interest of 15 percent or more (that's 391 percent annualized). As a guarantee, the borrower provides a post-dated check or authorizes the lender to access a bank account electronically. Variations include title loans and installment loans, in which borrowers pledge collateral ranging from cars to chainsaws.

The Consumer Financial Protection Bureau, set up by the 2010 Dodd-Frank Act, is preparing to write the first-ever federal rules governing such lending. At stake is the future of an industry that's a tiny part of the multitrillion-dollar U.S. financial sector but touches tens of millions of people each year and has made some of its practitioners very wealthy.

It's worth asking why the business should be regulated at all. If rational consumers choose to spend about $9 billion every year on interest and fees, then fast access to cash must be worth at least that much to them. On the face of it, restricting or banning the service would make them worse off.

What this ignores is that people make mistakes -- and that the industry likes to help them do so. Most borrow too much, forcing them to extend repeatedly, racking up fees and interest that far exceed the principal. Some lose the cars they need to get to work, or they struggle to pay rent after lenders make their electronic withdrawals.

Lenders know that chronic overborrowers are the most profitable. They make retiring loans difficult by requiring customers to choose between paying the whole principal or extending the loan. They exploit inattention by renewing loans automatically unless otherwise instructed, extracting new fees each time. In the worst cases, they make unauthorized withdrawals and rely on harassment and intimidation.

That said, if you need $300 to fix your car and get to work and you have no other choice, even an extremely expensive loan might be worth it. The question, then, is where to set the boundaries.

Colorado has what looks like a promising answer. In 2010, the state put a cap on finance charges, and it required principal and interest to be payable over at least six months, with no penalty for early payment. The average annual rate on loans fell to 115 percent from more than 300 percent. Paying down loans became much easier: On average, the next required installment fell to 4 percent of the borrower's income. And the service remained available to those who needed it.

The Consumer Financial Protection Bureau doesn't have the power to cap finance charges, but it can do something similar: Warn lenders that they could get in trouble for making unduly onerous loans, and set a share of income -- say, 5 percent -- below which it will presume loan payments to be affordable. It can also tell lenders to set out the total cost of borrowing in simple terms, and cast its net widely, to cover all kinds of small-sum, short-term lending.

Colorado's reform shows that payday lending doesn't have to be predatory. The CFPB's new rules can help ensure that it isn't.

To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net.